Finalized Guidance Document Concerning the Implementation of Basel III

Wrong-Way Risk As a summary, ‘’Wrong-way risk substantially applies only to IMM banks and is typically defined as an exposure to a counterparty that is adversely correlated with the credit quality of that counterparty’’ (Transactions with counterparties such as financial guarantors). However, there are implications for the Standardized and IRB Approaches as described in p.36. As a summary: • 2 types of wrong way risk • General wrong-way risk (GWWR) • Specific wrong-way risk (SWWR) • GWWR arises when the PD of the counterparties are positively corrected with general market risk factors • Arises from purchase of credit protection via CDS from mono-line insurers • Banks must identify exposures that give rise to general WWR: ■ Stress testing and scenario analysis to be conducted ■ Monitor general wrong way risk by product, by region, by industry etc. ■ Reports to be provided to Senior Management and Board on a regular basis Implement an explicit Pillar 1 capital charge and revise Annex 4 1 where specific wrong-way risk (SWWR) has been identified • Banks exposed to SWWR if future exposure to a counterparty is highly correlated with the counterparty’s PD • Banks need to have explicit procedure for identifying, monitoring and controlling specific WWR • Specific WWR charges applies for where there exists a legal connection between the counterparty and the underlying issuer e.g. ■ Single name credit default swaps ■ Equity derivatives referencing single counterparty ■ CDS (Credit Default Swaps): use expected loss assuming underlying in liquidation (LGD for swap = 100%) ■ Equity, bond, securities financing EAD= value of transaction under JtD (jump-to-default) 100. In specific, Paragraph 57 of Annex 4 1 in Basel II will be revised as follows to explain the following aforementioned summary on wrong way exposures: 57. Banks must identify exposures that give rise to a greater degree of general wrong-way risk. Stress testing and scenario analyses must be designed to identify risk factors that are positively correlated with counterparty credit worthiness. Such testing needs to address the possibility of severe shocks occurring when relationships between risk factors have changed. Banks should monitor general wrong way risk by product, by region, by industry, or by other categories that are germane to the business. Reports should be provided to senior management and the appropriate committee of the Board on a regular basis that communicate wrong way risks and the steps that are being taken to manage that risk. Implement an explicit Pillar 1 capital charge and revise Annex 4 1 where specific wrong-way risk has been identified 101. In order to implement the requirement that the EAD calculation reflect a higher EAD value for counterparties where specific wrong way risk has been identified, paragraph 423 of the Basel II text and paragraphs 29 and 58 of Annex 4 will be revised as follows: 423. Each separate legal entity to which the bank is exposed must be separately rated. A bank must have policies acceptable to its supervisor regarding the treatment of individual entities in a connected group including circumstances under which the same rating may or may not be assigned to some or all related entities. Those policies must include a process for the identification of specific wrong way risk for each legal entity to which the bank is exposed. Transactions with counterparties where specific wrong way risk has been identified need to be treated differently when calculating the EAD for such exposures (see paragraph 58, Annex 4 ). 1 29. When using an internal model, exposure amount or EAD is calculated as the product of alpha times Effective EPE, as specified below (except for counterparties that have been identified as having explicit specific wrong way risk – see paragraph 58): 58. A bank is exposed to “specific wrong-way risk” if future exposure to a specific counterparty is highly correlated with the counterparty’s probability of default. For example